Adam Hamilton November 14, 2014 2951 Words
This latest capitulation by gold-stock investors has left this hated sector at truly apocalyptic lows. Bearish consensus is so extreme that pretty much everyone believes the gold miners are doomed to spiral lower forever. But today’s horrendous gold-stock price levels aren’t righteous, they’re a temporary emotional fiction conjured by epic fear. Trading at fundamentally-absurd levels, gold stocks are due to mean revert far higher.
For 15 full-time years now, I’ve been deeply immersed in the financial markets as a speculator, investor, researcher, and newsletter writer. During that long fascinating and challenging span, I’ve had to weather every imaginable market storm. They’re never easy, with the temptations to succumb to popular extremes of greed and fear always great. The critical anchor necessary to avoid being swayed by these emotions is perspective.
Perspective is keeping the bigger picture in focus, and comes from both trading experience and studying market history. Perspective effectively combats the tyranny of greed and fear over trading decisions, by deescalating the overwhelming emotional dominance of the present. Most traders only consider recent price action when making their trading decisions, which is dominated by prevailing and misleading emotions.
And that’s why epic fear has smothered gold stocks. Their technical price action over recent weeks and months has been an unmitigated disaster. As they get hammered ever lower day after day, it seems like the gold-stock Apocalypse is upon us. A terrible bearish vicious circle has formed, with falling prices leading to rampant selling which hammers prices even lower. It sure feels like gold stocks are forever broken.
But healthy perspective far transcends the feelings that lead traders to make wealth-killing decisions like buying high and selling low. Like all stock sectors, gold mining is simply another business that generates cashflows, profits, and dividends. Ultimately these underlying fundamentals will determine the righteous gold-stock price levels over the long term. Fundamentals eventually trump short-lived greed and fear extremes.
Gold-mining profitability, and hence ultimate stock-price levels, is driven almost exclusively by the price of gold. Gold miners invest hundreds of millions to billions of dollars in developing deposits into operating mines. And in each individual one, the costs for wresting that precious metal from the bowels of the earth are largely fixed in the pre-construction mine-engineering phase. So all that really matters is the gold price.
And gold has certainly weakened in the past couple months, falling on extreme gold-futures shorting by American speculators. But year-to-date, gold is only down a modest 3.9%. Yet the flagship gold-stock index known by its trading symbol HUI has plummeted 18.8%. Gold stocks are collapsing far faster than the lower gold prices warrant, which is not rational or justified fundamentally. Their operating profitability is still good.
Like all low-price extremes, gold stocks’ recent lows were driven solely by an emotional capitulation. Many long-suffering gold-stock investors and speculators finally gave up, surrendering to sell low. The fear in their own hearts grew so suffocating that they could no longer withstand the crushing pressure of being in this losing trade. So they dumped gold stocks not because profits collapsed, but because fear beat them.
This extreme emotional selling has left gold stocks at truly fundamentally-absurd levels. The word absurd means “ridiculously incongruous or unreasonable”. And that’s where gold-stock prices are today when compared to any conceivable valuation metric. They are far too cheap, trapped in an emotional fiction conjured by epic fear that will soon dissipate. When that happens, gold stocks will soar in a huge mean reversion.
This first chart restores critical perspective with a secular view of gold stocks and gold. I had to use the venerable HUI gold-stock index here because the popular GDX gold-stock ETF’s history doesn’t extend back far enough. GDX was born in May 2006, but to see the last time gold stocks traded at today’s levels we have to travel years farther back beyond that. But GDX perfectly tracks the HUI, so this analysis applies to it too.
Just last week, extreme fear-driven selling hammered the HUI to 147. Investors and speculators alike fled gold stocks in droves, losing the battle in their own hearts against the overwhelming popular fear. They couldn’t stand the pain anymore and wanted out at any price, so they sold low. That’s really unfortunate, as buying high and selling low is the surest path to financial ruin. Capitulations are never rational events.
Since their all-time record high in September 2011, gold stocks as measured by the HUI yardstick have lost a gut-wrenching 76.9% in 3.2 years. They had bottomed decisively in mid-2012, but then the US Federal Reserve started levitating general stock markets with its wildly-unprecedented third quantitative-easing campaign. So capital started to migrate out of alternative investments, a realm long dominated by gold.
Gold drifted lower, fell, and even plunged. The epicenter of this mass exodus was the second quarter of 2013, the worst quarter for gold in an astounding 93 years! Stock investors fled gold by dumping shares in the flagship GLD gold ETF at epic record rates. As gold spiraled lower, the gold miners were naturally sucked into the maelstrom. Their whole fundamental outlook and future profitability totally depends on gold’s price.
While gold stocks indeed should’ve been sold with gold weaker, the magnitude of selling they suffered was far beyond anything justifiable fundamentally. This ultimately culminated in the latest gold-stock capitulation where the HUI plunged to 11.3-year lows! Think about that a second. Gold stocks were just trading at prices not seen since July 2003. Pretty much the entire secular gold-stock bull had been fully erased.
That’s pretty crazy to contemplate. Between November 2000 and September 2011, the HUI rocketed an astounding 1664% higher during a period where the benchmark S&P 500 drifted 14% lower. Gold stocks were the best-performing sector in the world during their secular bull, earning fortunes for their investors and speculators including me and our newsletter subscribers. It was one of the greatest stealth bulls in history.
But as of last week, over 4/5ths of that bull run had vanished. And that entire not-widely-followed gold-stock bull was based on the massive fundamental boost to gold-mining profits that gold’s own secular bull created. So if the recent gold-stock price levels were righteous, gold too should have been pounded back down towards its mid-2003 levels. Where was gold trading back then? Merely right around $350!
Three-hundred-and-fifty-dollar gold, that’s incredible. I was trading gold stocks and writing newsletters back then too, building fortunes for contrarian investors brave enough to buy low. Believe me, this has never been an easy sector to own. It’s not only super-volatile and emotional, but gold and therefore gold stocks will always be hated by Wall Street because they compete with general stocks for scarce investment capital.
Do gold stocks deserve to trade today as if gold was at just $350? Heck no! Last week when gold stocks’ latest capitulation low was carved, the gold price was up near $1150. That was 3.3x higher than the last time the gold stocks traded at recent levels! It makes no fundamental sense whatsoever for gold stocks to trade as if gold was at $350 when it was actually $1150. Their core fundamentals are now vastly better.
At my company Zeal, we’ve done and continue to do extensive and deep studies on gold miners as a sector. We are constantly looking at their profitability, cost profiles, operating cashflows, and a wide array of hard financial metrics. And despite major write-offs of gold projects forced by the past couple years’ extreme once-in-a-century gold-price anomaly, gold miners’ underlying fundamentals remain rock-solid.
This whole sector is truly in infinitely better financial shape than it was 11 years ago the last time the HUI traded at recent levels. And as gold inevitably mean reverts higher out of its own recent extreme lows, the current and future profitability for mining gold will soar. So it is extremely illogical, fundamentally absurd, for gold stocks to be priced as if gold was at $350 when it is actually $1150. This is confirmed the other way.
The recent extreme gold-futures selling hammered gold to a 4.5-year low, a far-shorter span than the 11.3-year HUI gulf. The last time gold traded in the $1140s in April 2010, the HUI was between 425 and 450. Without today’s unbridled explosion of fear, I strongly suspect that’s exactly where gold stocks would be trading again. HUI 400 or maybe even 350 could easily be considered righteous and rational, but 150? No way.
The awesome thing is such temporary emotional fictions created by extreme greed or fear soon pass. The collective herd emotions in the markets are finite, with extremes short-lived. Once everyone susceptible to being scared into selling low is already out, there are no more sellers. So soon the great sentiment pendulum starts slowly swinging back through its greed-fear arc towards the opposite end. Thus gold stocks soar.
The only comparable episode to today’s gold-stock extremes came back in late 2008’s stock panic. That too was a once-in-a-century fear super-storm, the first stock panic since 1907. Back then, like recently, gold-stock investors and speculators universally capitulated and sold low. They believed that because gold stocks had plummeted and shattered all technical support, there was no hope and this sector was doomed.
But nothing could’ve been farther from the truth! Coming out of those 5.3-year stock-panic lows, also the worst HUI levels since July 2003, gold stocks skyrocketed. Over the next several years, the HUI more than quadrupled with a gigantic 319% gain! And that was over a span where the S&P 500 merely rallied 40%, again the gold stocks were one of the world’s best-performing sectors. Extreme lows portend huge upside afterwards!
And fundamentally, the recent HUI lows were even crazier than this straight-up HUI-and-gold comparison indicates. This next chart looks at the best gold-stock valuation metric, the HUI/Gold Ratio. This HGR distills the key fundamental relationship between gold-stock prices and the metal that drives their profits. And amazingly, apocalyptically, gold stocks have actually never been cheaper relative to gold prices!
When the HGR is rising, gold stocks are outperforming gold. That is normal during periods of rising gold prices all throughout history. Conversely when the HGR is falling, gold is outperforming gold stocks. This typically happens when gold is weakening, as the gold stocks with profits leveraged to the gold price fall faster. Incredibly, this latest capitulation has crushed gold stocks to an all-time low in HGR terms!
The NYSE Arca Gold BUGS (Basket of Unhedged Gold Stocks) Index or HUI was born in March 1996. In the entire 18.7 years since, this leading gold-stock metric has never been as cheap relative to gold as it was last week. And this includes those final dark years of gold’s last secular bear in the late 1990s! So I strongly suspect this is an all-time record low of gold-stock prices relative to gold, their most extreme fear ever.
Last week the HGR actually slumped to 0.128x. In other words, the price level of the HUI was trading at just over 1/8th the gold price. This secular HGR chart really highlights just how anomalous and extreme that is. Even during 2008’s once-in-a-century stock panic, the biggest fear event most of us will ever witness in our lifetimes, the HGR merely plunged to 0.207x. Today’s gold-stock bearishness even exceeds that.
To gain that critical perspective showing how fundamentally-absurd today’s apocalyptic gold-stock prices are, consider some long-term comparisons. Before the Fed launched its hyper-manipulative QE3 to wildly distort global financial markets, the normal years in the post-panic era were 2009 to 2012. During that span, the HGR averaged 0.346x. Merely to mean revert to there, the HUI would have to soar 169% higher!
And back in the secular span from mid-2003 to mid-2008 before that stock panic, the HGR averaged a far-higher 0.511x. To return to that pre-panic normalcy measure, the HUI would have to quadruple from here even if gold did absolutely nothing. It is just mind-boggling how ludicrously low today’s gold-stock price levels are compared to all precedent. It’s supremely irrational, reflecting the radically-illogical fear out there.
This epic anomaly can’t and won’t last for long. Capitulations, by their very nature, force all weak-handed investors and speculators out of a bottoming market. Fear has already peaked, and burned itself out. The traders who remain in gold stocks are the hardcore contrarians who maintain long-term perspectives and understand gold stocks’ dazzlingly-bullish fundamentals. They are not going to be suckered into selling low.
Peak fear means a sharp mean reversion higher is imminent, both in absolute HUI and HGR terms. The gold-stock behavior in 2009 coming out of their last extreme fear event shows what to expect. As traders start to bargain hunt in this beaten-to-a-pulp sector, gold-stock prices accelerate higher. These big gains entice in new investors, forming a virtuous circle. More buying drives gold stocks higher, begetting more buying.
The inevitability of this mean reversion is sealed by the perpetually cyclical nature of the markets. Gold stocks have actually been losing ground on balance relative to gold since early 2006, a very long 8.6-year secular span. Nothing in all the markets, including the ratio of gold-stock prices to gold, moves in one direction forever. Cyclicality guarantees gold stocks are overdue for a long period of outperformance again.
And the upside in this left-for-dead sector when the cycles shift is utterly massive. There is absolutely no doubt the HGR will return to its post-panic average of 0.346x, once again a 169% gain from here. But the upside potential of gold stocks is far greater than that. After emotionally-driven extremes, prices nearly always overshoot dramatically in their mean reversions. Think of that great greed-fear pendulum again.
Gold stocks were dragged so far to the fear side of that arc that the pendulum was practically ripped from its mounting. It’s never been higher, had more potential energy to convert into kinetic energy as it swings back the other way. Pulled so high, there’s no way the pendulum is going to magically stop in the middle with greed and fear balanced. Its kinetic energy is going to swing it deep into the greed side once again.
So the HGR is ultimately headed a lot higher as gold stocks mean revert. 0.40x seems like an easy bet, but it could very well swing to 0.50x or even 0.60x if gold stocks regain favor in a big way again. On top of that, gold itself is due to mean revert far higher as well. Especially when these artificial Fed-levitated stock markets decisively roll over and investors scramble to reestablish prudent positions in alternative investments.
To get back to where it was before last year’s QE3-driven once-in-a-century anomaly, gold would have to rally nearly 50% to $1675 or so. Plug a 0.40x HGR into that, and you get a conservative (not dependent on popular greed) HUI target of 670. That’s a 350%+ upleg from the HUI’s recent capitulation lows! And it is right in line with the past two massive multi-year gold-stock uplegs of 350% and 319%, certainly nothing special.
The Greek word behind the English Apocalypse means doom, but also revelation. And the latter sure fits gold stocks today. Far from being doomed as is universally believed, gold stocks are on the verge of a gigantic mean-reversion upleg that will unveil them to a whole new generation of gold-stock investors. This will include large professional investors like hedge funds, eager to buy a small and despised sector dirt-cheap.
It’s never easy buying deeply-out-of-favor stocks, and even harder holding them if they fall even farther out of favor after you deploy capital. But if you’ve ever liked gold stocks in the past, you’ve got to just love them today trading at such extreme lows. They’ve literally never been cheaper relative to gold, an epic buying opportunity for contrarians tough enough to fight the herd and buy low when few others are willing to.
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The bottom line is the recent apocalyptic gold-stock capitulation left this sector as cheap as it’s ever been relative to gold. Nearly everyone believes the gold miners are doomed, but nothing could be farther from the truth. With these stocks now trading at levels last seen when gold was around $350, the upside potential in this left-for-dead sector is vast. Gold-stock prices are fundamentally absurd and overdue to mean revert.
Contrarians tough enough to fight the herd and buy low are going to multiply their fortunes, again. After the last time gold stocks traded at remotely-comparable lows in 2008’s stock panic, they were destined to more than quadruple over the next several years. No sector moves in one direction forever, or remains disconnected from its underlying fundamentals forever. And this certainly includes the despised gold stocks.
Adam Hamilton, CPA November 14, 2014 Subscribe at www.zealllc.com/subscribe.htm